Volatility Clustering FAQ

What is volatility? Volatility is the rate at which the price of a security moves up and down. Volatility is a type of risk found in financial instruments.

How do you measure volatility? There are many ways to measure volatility, including measures of standard deviation, frequency of “large” day-to-day swings or frequency of large daily high-over-low ratios. All of these are direct measures of an instrument’s past volatility. A measure of forward looking or expected volatility of a stock market index can be found by using the VIX Index or also known as the fear gauge.

What is the VIX Index? VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of volatility. The VIX Index is equivalent to the expected annualized standard deviation for the S&P 500 over the next 30 days. The index is available on a daily basis. Certain types of derivative instruments, called options, are tied to the price movement of an associated financial instrument or index. These options are very sensitive to what the market thinks will be the forthcoming volatility experienced by the instrument or index. Using advanced mathematics, a specific numerical estimate of the market’s outlook for volatility can be extracted from any given option.

What is Volatility Clustering? Back in the early 1960s, financial researcher Benoit Mandelbrot observed a phenomenon that occasionally and irregularly affects stock markets, which he called “Volatility Clustering.” Mandelbrot noted that when it comes to stock market volatility, large changes tend to follow large changes, of either sign, and small changes tend to follow small changes. In other words, volatility begets volatility, and such periods of large market swings are called a Volatility Cluster. (Aspects of work by financial economist and Nobel Laureate Eugene Fama were greatly influenced by Mandelbrot’s work.)

Typically an external event, such as a series of poor earnings announcements or negatively surprising economic reports, will cause a rapid spike higher in volatility, which then stays at elevated levels for anywhere from a week to as long as six months. A new volatility spike can occur in the middle of a current Volatility Cluster, since they are often triggered by external events in the economy such as monetary policy or geopolitical changes. This can make it hard to identify any one Volatility Cluster’s start and end point.

How is volatility different from return? Is volatility just a downward move in the market? Volatility is not simply the tendency of a stock index to fall in value. When an index such as the S&P 500 falls, that is simply a negative return. When the index rises, that is a positive return. Volatility is a measure to help market analysts express whether, over a given period of time, an index has experienced larger vs. smaller gains and losses. Volatility does not presume that the market is falling or rising when it is measured; it simply speaks to the degree to which periodic returns in the market are, on average, either of a large size or a small size.

If volatility does not take market trend into account, is there no relationship between market direction and the level of volatility of the market index? There is no specific mathematical reason why volatility should be higher or lower just because a market is trending upwards vs. downwards. However, researchers long ago discovered that when markets trend lower, various measures of volatility move to a higher level and when markets rally, measures of volatility tend to move lower. There is no clear reason for this empirical relationship, although behavioral finance researchers believe that it is related to the human tendency towards risk aversion, particularly the human response to become more risk averse after experiencing losses.

If high levels of volatility persist following a volatility spike, is this exploitable? Is it a factor in your analysis of markets or in the positioning of your portfolios? Oddly enough, Volatility Clusters are not predictive of anything in the markets. They appear to be more of a reaction to the market and external events rather than as either precursors or driving factors of the stock market. Researchers and financial practitioners have tried to utilize predictive models such as ARCH and GARCH to predict volatility. The results are neither conclusive nor comprehensive.

If Volatility Clusters have no useful value in the investment process, why do we examine them or discuss them? There is an educational value in understanding that a Volatility Cluster is underway. It is one of many behavioral finance features of the marketplace that we feel are important to understand. Volatility Clusters seem to go hand-in-hand with — and indeed are probably caused by — a downtrend in the market. They appear to last just about as long as the market is in decline and the Clusters settle down as the stock market finds its bottom and starts heading higher. We bring this association between Volatility Clusters and market corrections to your attention to help investors realize that during a market correction they are going to feel additional anxiety, not just because the market is falling but also because volatility itself, which is much higher during the Cluster, is its own separate form of anxiety. Markets will drop sharply on any given day during a Cluster, and they will also give repeated false senses of recovery by exhibiting sharp recoveries on a single day which then fail to sustain. This is the very definition of higher volatility. But downturns eventually reverse and consequently volatility also declines, so clients should not be excessively concerned about wide daily swings during market downturns.

The views expressed represent the opinions of the author which are subject to change and are not intended as a forecast or guarantee of future results. Stated information is provided for informational purposes only, and should not be perceived as investment advice or a recommendation for any security. While Loring Ward believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and the author's view as of the time of these statements. Actual results, performance or events may differ materially from those expressed or implied in such statements. past performance of various investment strategies, sectors, vehicles, and indices are not indicative of future results.